More Comments on Principles-Based Regulation

1. I think that many people are missing an important feature of principles-based regulation, which is the role of audits in producing compliance. I will explain that in the next post on the topic.

2. One principle I want to implement is "Don't scam customers, especially those who can't afford it."

I think that many people have poor financial knowledge. They don't understand discounting to present value, so when they hear that they can "save thousands of dollars on their mortgage" by switching to biweekly payments, then do not realize that in present value terms these savings amount to very little. They don't understand the concept of insurance, so they will pay a lot of money to protect against small losses.

We know a very poor woman who has bought "burial insurance" several times. Each time, she misses a payment, the policy is canceled, and she has to start over.

I am offended by the businesses and people who exploit these sorts of human weaknesses. I would actually feel pretty good about my "contributions" (taxes) if they were being used to protect potential victims of these scams and punish the scammers.

3. A second principle is, "Don't exploit your government guarantee." Yes, the surest way to keep banks from exploiting guarantees is to not issue any guarantees. But we are not in that world. Exploiting the guarantee means earning returns by loading risk onto taxpayers. You can do this by scrimping on management controls, by taking large bets, by maintaining too small a capital cushion, etc. In my previous post, I provided Kyle's eloquent summary of why I do not think that rules-based regulation will succeed in stopping banks from exploiting guarantees.

4. If you assume malice on the part of regulators, then I will grant that principles-based regulation will fail. My claim is that bright-line regulation fails even if you assume no malice on the part of regulators.

5. The way I see it, common law is an "existence proof" for law that is not hard-coded into written rules. Police, prosecutors, judges, and juries all exercise discretion in our system. We can quibble over how much discretion is optimal, but zero is not self-evidently the right answer.

He puts forth the idea of principles-based regulation in hope that it will reduce the regulatory burden incumbent upon firms.

I do no such thing. I want to change the nature of the regulatory burden. It is my hope that it will reduce increase the regulatory burden for "bad" firms (ones that are otherwise inclined to violate the principles) and perhaps reduce it for "good" firms.

Comments and Sharing

Clearly it is not possible to build finance structures that will not scam customers. But at the very least, some could build a reputation for protecting previous payments as per your example, and also others might exist to provide targeted asset building on a small scale for poor people who could buy living components a bit at a time. Those with the 'good' reputations would doubtless find their way to poor customers with the help of the public.

Principles-based regulation is really about flexible guidelines that we need in many areas of our lives - especially given rapidly changing times such as now. Such flexible guidelines are simply the intellectual equivalent to the flexible components one might provide for a skyscraper, built to withstand the next earthquake.

On (2) I agree that it is appalling for businesses to exploit financial ignorance. But how do we tease apart such exploitation from caveat emptor?

On (3) an idea that I have not seen discussed much is creating some sort of escrow account funded by mandatory contributions from banking and financial institutions, that would serve to provide bailouts. Perhaps it is naive. I also have not seen much discussion about the role of interest rates: if the Fed were to raise rates, many financial institutions would find it optimal to lower the riskiness of their projects, particularly if (like some pension plans) they have a target in mind, e.g. 8 percent.

Arnold, this seems to sit uneasily with Hayek's argument from e.g. _The Constitution of Liberty_ that a free society is one in which people are subject as little as possible to the discretion of magistrates, rather than to impersonal rules known in advance by all and evenhanded in both enactment and enforcement.

How do you reconcile this? Do you think Hayek was wrong? Do you think PBR actually better embodies his idea because the principles can be more impersonal and better understood in advance than regulations? Or...?

3. A second principle is, "Don't exploit your government guarantee." Yes, the surest way to keep banks from exploiting guarantees is to not issue any guarantees. But we are not in that world.

The logic goes like this:

1. There is a problem A.
2. The surest solution is B.
3. We are not in a world of B.
4. Do C.

My first response to point 3 was "Duh: see 1 & 2". I thought I must be missing something. But I've seen this reasoning on these blogs several times now and its appearing to me to be the choice cop-out of social scientists.

4. If you assume malice on the part of regulators, then I will grant that principles-based regulation will fail. My claim is that bright-line regulation fails even if you assume no malice on the part of regulators.

You have only have to assume that regulators lack incentives, or sometimes information, to make decisions that are actually in the public interest.

You do not have to assume malice (although in practice it often looks that way).

When we look at what the regulators actually did during the financial crisis, do you see a lot of evidence that they tried to stop the problem but were hampered because they were confined by bright lines? I do not. What I recall is repeatedly being told there was no crisis and the fundamentals were sound until the crash was undeniable, at which point we were repeatedly told the crisis was over and green shoots were sprouting. First they didn't believe the crash was coming, once they knew they lied about it, and once the crash arrived they bent their efforts toward protecting the banks and screwing the taxpayer. How is giving those guys bigger and broader powers supposed to help ordinary Americans?

(Oh, wait, they did pick Bernie Madoff as a scapegoat and got him in the press every day for a while, who of course had nothing to do with the actual financial crisis.)

Your general argument is of the form "because bad stuff happened and the authorities didn't stop it, we must give the authorities more power". This is not an uncommon argument, though it's a bit surprising from someone who leans libertarian.

You seem to discard the possibility that giving authorities more power could actually make things worse than they were. Hey, the old way failed, so what have we got to lose?

I do not recall if you were opposed to the various executive power grabs we saw with GB II and Obama. If new, broad, and discretionary powers are good for financial regulators, why shouldn't they also be good for executives? There are lots of different kinds of bad things happening in the world, and frequently the authorities are outwitted by the bad guys or limited in their actions. Shouldn't we give more power to authorities of every class so they can stop the bad people?

Blogging software: Powered by Movable Type 4.2.1.
Pictures courtesy of the authors.
All opinions expressed on EconLog reflect those of the author or individual commenters, and do
not necessarily represent the views or positions of the Library of
Economics and Liberty (Econlib) website or its owner, Liberty Fund,
Inc.

The cuneiform inscription in the Liberty Fund logo is the
earliest-known written appearance of the word
"freedom" (amagi), or "liberty." It
is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.